The Problem with Traditional Contracting in Australia’s Building and Construction Industry
18 September, 2024
While it is true that Australia’s economic success largely hinges on the resources, commodities and mining sectors, there is no doubt that the contributions of the building and construction industry are frequently overlooked. Per the Australian Bureau of Statistics, from June 2022 to June 2023, the total value of building and construction work completed in Australia was $269.72 billion, equivalent to approximately 10.5% of GDP that year (ABS, 2023). Additionally, according to data released at the end of 2023, the building and construction industry accounted for a 9.4% share of the total labour force (employing over 1.3 million people), further highlighting the crucial role the industry plays in the continued vitality of the Australian economy (Master Builders Australia, 2023). The following article briefly delves into the traditional approach to contracting widely seen across Australia’s construction industry, identifying some of the major issues with this method, and then highlights a few emerging alternatives such as alliance contracting and incentivised target cost models.
Traditional/Conventional Contracting in Construction Projects
Traditional/conventional contracting, often referred to as lump-sum contracting in large-scale construction or infrastructure projects, generally involves concentrating the project’s design and delivery risks at a single point: the Contractor/Supplier. The most common variation of this model, referred to as Design & Construct (D&C), sees a fixed, lump-sum price contract (price cap) and a fixed completion date by which the Contractor must improve upon the Owner’s initial limited design and then construct to that design (hard obligation accompanied by a liquidated damages clause for late completion). Further, there is a structured and pre-determined claims regime in place, often with strict time bars (how much time a party has to provide notice of a claim) for the recoupment of cost or time relief by the Contractor (Taqi and Gu, 2024). Thus, a core feature of D&C models is that almost all of the design and construction risk is borne by the Contractor. The purpose of D&C models is to mitigate ‘interface risks’ between the design and construction processes, as well as to identify very clear and enforceable obligations between the parties from the onset of the procurement process (Standing Committee on Infrastructure, Transport and Cities, 2021). As noted by the Australian Constructors Association, traditional/conventional construction contracts have their place, and may be ‘perfectly suited for projects with a clearly defined scope and well understood risks’ (Standing Committee on Infrastructure, Transport and Cities, 2021). However, issues arise when the nature of the projects become more complex and challenging. Further, there are a number of valid criticisms of the traditional contracting approach seen in Australia, supported by notable productivity lags and exploding project costs due to overruns, disruptions and disputes. In fact, a widespread study conducted in 2021 by an Australian-based firm estimates that on average, 2.6% of total project costs are absorbed by disputes. It has been forecasted that the Australian government will spend approximately AUD$248 billion on construction projects between FY2021/22 to FY2024/25, which means that dispute costs alone could account for over $6.45 billion dollars, and this figure relates to government-owned projects only (Rudge, Fitzsimon and O’Shea, 2023). There is clearly much to be desired, and the move away from traditional contracting may just be the answer.
Primary Criticisms of Traditional Contracting
The competitive bidding process results in underestimated lump-sum prices along with the exploitation of the D&C model. Throughout the tendering process, Contractors compete with one another to present the lowest-cost delivery price to the Project Owner. In doing so, two primary issues can and do emerge:
(a) ‘Optimism bias’, which is where prospective Contractors fail to propose a lump-sum price that accurately reflects the ‘ultimate cost’. This can occur due to price escalations during the project’s life caused by external factors (weather, geopolitical environment, labour and supply shortages, etc), as well as an overly optimistic view of business capability during initial planning stages (Taqi and Gu, 2024). Price underestimation of this sort is becoming more common as the Australian economy is in the midst of a per-capita recession, with inflation remaining high while interest rates are anchored. Economic conditions are uncertain, and so investment in construction projects is stagnating, while skilled labour shortages are on the rise due to increasing unemployment. The COVID-19 pandemic continues to have negative reverberation effects on the construction supply chain, with global geopolitical unease due to various conflicts presenting a large risk of supply and demand shocks for critical materials. Due to a combination of these factors, the gap between the proposed fixed lump-sum price and actual costs appears to be widening for many projects across Australia.
(b) Intentionally low-balling to then take a dispute-based approach: as identified by the Australian Small Business and Family Enterprise Ombudsman, “…savvy, well-lawyered, well-resourced businesses will put a price in to win the work and then set their people to get the variations and game the process to get a margin” (Standing Committee on Infrastructure, Transport and Cities, 2021). In other words, a Contractor will knowingly provide an unrealistically low price at the tendering stage to secure the work, and then exploit the D&C process by preparing for and submitting a number of cost or time claims, earning back their desired profit margins in lengthy, inefficient disputes, instead of focusing solely on successful delivery. This practice aligns well with the next major criticism of traditional contracting outlined below.
Traditional contracting has created a ‘blame-game’ and adversarial claims-based culture in Australia’s building and construction industry:
Many argue that due to the nature and structure of traditional contracting processes, a culture of dispute and litigation has arisen across Australia’s construction industry, creating a low-trust environment for Project Owners and Contractors. Due to the fact that lump-sum D&C contracts rely on unbalanced risk allocation, there are claims that they drive poor outcomes due to a clear misalignment of commercial interests and an inherent inability to maintain collaborative relationships. There is a general fear of accountability and a strong desire for Contractors to utilise dispute pathways to recoup any costs that exceed the lump-sum price. Traditional/conventional contract terms do not encourage the sharing of knowledge and data, and in fact, often result in parties being held accountable (in the sense that they may be unable to recoup costs) for everything that they do share (Standing Committee on Infrastructure, Transport and Cities, 2021).
The approach is in need of an overhaul, one that addresses unfair risk allocation while providing incentives for improved productivity through active collaboration, transparency, information reuse, and delivery-partner models. The Australasian BIM Advisory Board (ABAB) states that traditional/conventional contracting methods used for large-scale construction projects greatly reduce productivity by nature of the lack of shared responsibility. In fact, it estimates that around 30% of construction-activity effort is wasted due to non-collaborative processes. Additionally, ABAB posits that a ‘conservative’ 5% increase in construction-activity productivity, which could be achieved through the adoption of collaborative approaches such as shared Building Information Modelling (BIM) for example, could generate upwards of $3.1 billion dollars in savings annually by decreasing the number of Australian projects that are over-budget and over-time (Standing Committee on Infrastructure, Transport and Cities, 2021). So, it appears the solution is quite clear: moving away from conventional contracting to adopt a more collaborative approach across the entire industry.
The Solution: Collaborative Contracting
Broadly speaking, ‘collaborative contracting’ is a term that covers a wide range of contract models, all with a shared purpose to deviate from the traditional adversarial approach and instead adopt an interactive, long-term and relationship-based perspective. Ultimately, the goal is to foster and develop a ‘best for project’ delivery method, instead of relying on the misaligned commercial interests of Owners and Contractors. The most prominent feature of many collaborative contracting models is knowledge pooling: Project Owners and Contractors actively communicate and share information/resources throughout all steps of the pre-construction, planning and design phases of the project. This serves to ensure all risks are accurately identified and shared across both parties, and also aims to mitigate changes or variations in scope. As identified recently by the Centre for Independent Studies (CIS), scope changes are one of the leading causes of cost overruns for large-scale construction and infrastructure projects in Australia (Campbell, 2023). Further, important industry members such as BuildingSMART Australasia and Lang O’Rourke argue that collaborative contracting promotes improved productivity by allowing for an integrated approach to scope outline, methodology and programming, one that does not rely on a claims-based cost recoupment structure (Standing Committee on Infrastructure, Transport and Cities, 2021). Collaboration promotes a more balanced management of interface risk and fosters a collective focus on project solutions instead of the maximisation of value to shareholders, as parties are jointly aligned to deliver on shared contractual obligations.
So, what does collaborative contracting look like in practice, and what are some of the forms it can take? We outline two upcoming approaches below, and recommend that Australia’s construction industry takes due note.
Alliance Contracting
The alliance contracting approach is what is known as an ‘integrated procurement method’, and usually necessitates the establishment of multiple integrated leadership teams comprised of members from all contracting parties, as well as the merging of resources/experience to ensure collective delivery on key project issues. Under this structure, a Government Owner forms a collaborative team with private suppliers (known as an ‘alliance’), under a single multi-party contract between the public-sector Owner and the non-owner participants (NOPs - such as Contractors, Engineers, Designers, Professional Consultants, etc). The core feature of the contract is that project delivery risks are jointly shared by all parties to the alliance, while most of the financial exposure arising from cost overruns or project delays is taken on by the Government Owner (cost-reimbursable model). Remuneration for the NOPs is not fixed and will consist of three main features: an agreed upon profit margin along with corporate overhead; direct and indirect costs; and, a ‘performance-based payment’ determined by comparing actual project outcomes to the desired completion date and the target costs. The goal is to include ‘best-endeavours’ obligations that function to redefine the culture of dispute-centric cost recovery and instead foster a unanimous approach that encourages the timely completion of project milestones, collective innovation and acting together in good faith. In fact, many alliance contracts actually include a clause that mandates all participants must agree to surrender their right to commence legal proceedings or make an official claim against other party members in relation to the scope of works, unless there is a ‘wilful default’ by a participant (limited legal liability) (Taqi and Gu, 2024) and (Tsirogiannis and Malesevic, 2024).
In Australia, the National Alliance Contracting Policy and Guidelines provides a comprehensive outline of best practice principles and contracting standards relating to alliancing for public Owners. The collection of documents can be found here, under the subheading, ‘Alliance Contracting’: https://www.infrastructure.gov.au/infrastructure-transport-vehicles/infrastructure-investment-project-delivery/national-guidelines-infrastructure-project-delivery#anc_alliance
It is important to note that while the benefits of alliance contracting are clear, this type of model tends to work best when dealing with high-risk, complex, publicly-owned projects that present large degrees of uncertainty during the pre-planning and tendering phases. For smaller-scale, privately-owned projects with rapid turnover dates, it may be the case that a traditional contracting approach could be more time efficient/appropriate due to the fixed lump-sum price and expressly separate contractual obligations. Further, it is true that the alliance contracting approach sees a substantial degree of financial risk for Government, but the hope is that by nature of the collaborative, team-based outlook, costs arising from overruns or delays will be minimised.
Incentivised Target Cost (ITC) Model
A less extreme/more flexible form of collaborative contracting, frequently referred to as the hybrid approach, is the incentivised target cost (ITC) model. This contracting method is currently far more commonplace within Australia’s construction industry relative to the pure alliance contracting strategy, and combines certain features of alliance contracting with some of the more onerous requirements of a fixed (traditional) contract, but ultimately, can be tailored to meet project needs on a case-by-case basis. When procuring under an ITC model, instead of a fixed lump-sum price, there is an agreed upon estimate of corporate overhead, reimbursable costs and necessary profits, which is known as the Target Outturn Cost (TOC). This is jointly determined at the tendering stage by both the Owner and Contractor (collaborative agreement). The Contractor’s performance is assessed against the TOC, and if the Actual Overturn Cost (AOC), which is often determined by an independent expert witness, is lower than the TOC, then the Contractor is allocated gainshare (a share of the calculated savings). Conversely, if the AOC surpasses the TOC, then the Contractor must share in the ‘pain’ (painshare) of the delays or cost overruns by facing a reduced profit margin. The standard has been that painshare or gainshare is allocated evenly (50% of cost overrun or project savings) between Owner and Contractor. However, the evenly split painshare payable by the Contractor is usually capped at the Contractor’s margin, at which point the Government Owner agrees to sustain a higher ‘pain’ threshold (noting however, in many existing/previous ITC models, if the AOC exceeds the TOC by a pre-agreed percentage level, then the Government Owner is entitled to ‘terminate the project deed’, or mandate that the Contractor ‘cures the default’). Further, from a time perspective, instead of the conventional approach of including liquidated damages clauses for late completion, there are key performance indicators (KPIs) and key results area (KRA) targets, which is an incentives-based approach where there are fee deductions or bonuses (per a daily rate) depending on whether these targets are met by the Contractor earlier or later than expected. Often, there are terms within the ITC contract that permit adjustments to the TOC, KPIs or KRAs, along with the targeted completion date, in accordance with a ‘collaborative behavioural framework’. Further common provisions include requirements to establish a ‘one-team culture’ to ensure that the parties actively work together to satisfy the performance targets and benefit from gainshares. Finally, according to the provisions of an ITC contract, all costs and pricing concerns must be claimed on a ‘fully open-book basis’ to allow for transparent auditing and information sharing (Taqi and Gu, 2024) and (Tsirogiannis and Malesevic, 2024).
The ITC hybrid model is a desirable contracting approach as it moves away from the unbalanced risk allocation and adversarial nature of traditional fixed-time, fixed-price contracts, while also including slightly stricter and more clearly defined obligations compared to the pure alliance contracting method. This is an emerging approach characterised by adaptability, but is still in the early stages of implementation and is yet to be standardised across Australia’s construction industry.
Conclusion/Executive Summary
In summary, it is evident than the traditional contracting approach is no longer viable when it comes to the successful delivery of large-scale construction and infrastructure projects in Australia. This is primarily due to complex global geopolitical conditions impacting construction supply chains, as well as a deeply ingrained culture of disputes and litigation, which combined has lead to frequent delays, significant cost overruns and reduced productivity across the industry.
HJA proposes that the future of construction in Australia is collaborative contracting, and this can take many forms, with two of the most common being alliance contracting and incentivised target cost (ITC) models. Both variations have their merits, and as Australia’s public sector continues to adopt collaborative contracting approaches – with a 2022 report by the NSW Government indicating that between 2021-22, the presence of collaborative contract models in construction/infrastructure projects increased from 18% to 30% – it is crucial that private Contractors adapt to ensure they don’t get left behind. It is HJA’s belief that the move from the outdated fixed-time, fixed-price approach – which places excessive risk on the private sector and promotes adversarial behaviour – to more collaborative risk sharing methods, could not come at a more perfect time. The future is here, and the health of Australia’s construction industry relies on change, not convention.
References
Australia Bureau of Statistics (2023). Construction Work Done, Australia, Preliminary, June 2023. [online] ABS.gov.au. Available at: https://www.abs.gov.au/statistics/industry/building-and-construction/construction-work-done-australia-preliminary/jun-2023#:~:text=In%20seasonally%20adjusted%20terms%20in [Accessed 30 Aug. 2024].
Campbell, G. (2023). Bungles, Blowouts and Boondoggles: why Australia’s infrastructure projects cost more than they should. [online] The Centre for Independent Studies. Available at: https://www.cis.org.au/publication/bungles-blowouts-and-boondoggles-why-australias-infrastructure-projects-cost-more-than-they-should/ [Accessed 30 Aug. 2024].
Department of Infrastructure and Regional Development (2015). National Framework for Traditional Contracting: The Guide Good Practice and Commercial Principles for Traditional Contracting. [online] Australian Government, pp.6–32. Available at: https://www.infrastructure.gov.au/sites/default/files/migrated/infrastructure/ngpd/files/NFTC_The%20Guide.pdf [Accessed 30 Aug. 2024].
Master Builders Australia (2023). Our Industry – Master Builders Australia. [online] Masterbuilders.com.au. Available at: https://masterbuilders.com.au/about-us/our-industry/ [Accessed 29 Aug. 2024].
Rudge, N., Fitzsimon, K. and O’Shea, J. (2023). Three ways to avoid construction project disputes. [online] Allens.com.au. Available at: https://www.allens.com.au/insights-news/insights/2022/07/three-ways-to-avoid-construction-project-disputes/#:~:text=A%20key%20concern%20here%20is [Accessed 30 Aug. 2024].
Standing Committee on Infrastructure, Transport and Cities (2021). 5. Collaboration and contracts. Inquiry Into Procurement Practices for Government-Funded Infrastructure, [online] Parliament of Australia. Available at: https://www.aph.gov.au/Parliamentary_Business/Committees/House/Former_Committees/ITC/Gov-fundedInfrastructure/Report/Section?id=committees%2Freportrep%2F024903%2F79247 [Accessed 30 Aug. 2024].
Taqi, J.E. and Gu, C. (2024). Tackling geopolitical challenges in Australia’s construction industry through collaborative contracting. [online] White & Case. Available at: https://www.whitecase.com/insight-our-thinking/constructing-low-carbon-economy-geopolitical-challenges-australias-construction [Accessed 30 Aug. 2024].
Tsirogiannis, N. and Malesevic, D. (2024). Incentivised Target Cost: a new way forward? [online] MolinoCahill - Melbourne, Australia. Available at: https://molinocahill.com.au/insight/incentivised-target-cost-a-new-way-forward/ [Accessed 30 Aug. 2024].
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